Chapter 9
Financial statement
analysis and financial
ratios
Understanding a companys financial statements is an essential step for
successful stock selection. Financial statements reveal the details of a
company’s operating and financial historical performance. Financial
authorities require timely dissemination of company financial statements
to the public, and investment analysts and fund managers use the data in
financial statements to identify problems or opportunities that might affect
existing or potential investments. Reported accounting data can be used for
comparing similar companies within an industry. The data is also utilized to
assess a company’s ability to meet financial obligations such as interest
payments and subsequently to determine bankruptcy risk. Analysts use
accounting data to predict future profitability of companies and to estimate
future rates of return in the stock market.
A public company’s annual report is a good primary source of company
financial information. Other sources such as specialized web sites are also
available, for example www.hoovers.com, and the SEC’s Electronic Data
Gathering and Retrieval archives (EDGAR) accessible at www.sec.gov. In
some countries, such as the US, the annual report is updated quarterly; in
others, reports are provided semi-annually. The formats and items listed on
the reports can also vary from country to country
Portfolio Management in Practice
The financial statement comprises the following three major financial
reports:
1 The income statement (also known as the profit and loss statement)
reports the companys operating performance over the accounting
period, and summarizes the company’s turnover and expenses
2 The balance sheet provides a ‘snapshot’ of the firm’s assets and liabilities
on a given date
3 The cash flow statement (or statement of sources and uses of funds)
reports how the firm generated cash and where it was utilized over the
accounting period.
Understanding the format and content of the above reporting statements is
crucial in order for analysts and fund managers to provide value-added
earnings and cash flow analysis. Accounting data are also useful in assessing
the economic prospects of the firm. Economic data used for valuation
purposes are based on available accounting data.
The three parts of the financial statement are discussed here in more detail,
along with a description of some of the more popular financial ratios used
to investigate the sources of a firm’s profitability and to evaluate the
soundness of the earnings.
The income statement
The income statement shows the profitability of the firm over a period of
time, such as a year or a quarter. It summarizes the flow of sales, expenses
and earnings during the designated period. The income statement is also
known as the profit and loss account, or P&L. It states revenues generated
during the operating period, the expenses incurred during that same
period, and the firm’s net earnings or profits (the difference between
revenues and expenses). The income statement helps investors to assess the
ability of management to produce profits and to control expenses.
Regarding expenses, four broad classes of expenses are considered:
1 Cost of good sold: the direct cost attributable to producing the product
sold by the firm
150
Financial statement analysis and financial ratios
2 General administrative expenses: the overhead expenses, including
salaries, advertising and other costs that are not directly related to
production
3 Interest expenses: interest paid on the firm’s debt
4 Taxes on earnings: taxes owed to federal and local governments.
The information contained in the income statement assists investors in
answering numerous questions they may have about the companys
profitability. First and foremost, did the company make a profit or a loss?
What has the trend in the revenues, costs and profit been over the last few
years? What were the primary sources of expenses?
Table 9.1 is a sample income statement for Company Z.
In this case, the company’s gross profits and net income have both gone up
over the past year. Even though all expenses were up apart from taxes paid,
the company experienced an extraordinary loss last year, which reduced net
151
Table 9.1 Income statement for Company Z (in millions $)
This year Last year
Net Sales 100 90
Costs of goods sold (30) (25)
Gross profit 70 65
Administrative expenses
(10) (8)
Operating income 60 57
Investment income 5 5
Interest expense
(3) (1)
Income before tax 62 61
Income taxes (14) (14)
Minority interest income
1 1
Profit after tax 49 48
Extraordinary items
0 (2)
Net income 49 46
Dividends
(12) (11)
Retained earnings 37 35

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